The fairy tale ends

Once upon a time, executives at i-shops used to tell anyone who would listen that the world was now conducting business on Internet time. They probably had no idea that the swift collapse of their industry would happen on Internet time as well.

* A year ago, even for a few months after Nasdaq's April 2000 crash, business walked in the door, not only from dot-coms, but also from bricks-and-mortar companies that were terrified of the dot-com threat. It was easy to post quarter-to-quarter revenue gains in the double digits. * Sure, there were occasional murmurs that the business would slow down at some point. But no one envisioned a "slowdown" that would slash valuations by more than 90%, cause numerous rounds of layoffs and result in several bankruptcies. So far.

No one thought that within one quarter there would be questions about the project-based business model upon which most i-shops are based. Now that model has been replaced by an emphasis on long-term clients.

But the worst may be yet to come. By yearend, the number of i-shops may be halved, or worse, analysts say. Bankruptcy has already claimed MarchFirst, which in 1999 rankings claimed the top spot in Advertising Age's Interactive 100 (see MarchFirst feature on P. S10).

As for the rest of the industry, the lucky ones will likely be acquired by suitors ranging from consulting companies to tech suppliers such as IBM to ad agency groups.

"Yes, companies are going to go bankrupt. Yes, companies are going to get bought," says Steven Birer, a managing director at investment bank Robertson Stephens who follows i-shop stocks. "The pyramid on which this whole thing had been built-the constant inflow of funds-dried up."

The headlines tell the tale. While the MarchFirst bankruptcy has made the most news, other companies have slashed staffs and seen their stocks plummet.

Ad agencies that invested in i-shops are trying to figure out how to recast their once sterling investments. True North Communications, prior to announcing its intention to be acquired by Interpublic Group of Companies in March, said it wanted to shed its 44.6% stake in Modem Media. In April, Omnicom Group shifted its minority stakes in Agency.com, Organic and Razorfish into a new e-services holding company to be co-managed with a venture capital unit of Pegasus Capital Advisors.

The move was seen by some as a way for Omnicom to get struggling stocks off of its books. But others indicated that the new company might be a consolidation play in which Omnicom and Pegasus would acquire other i-shops.

But if the potential consolidators are waiting for the business to hit bottom, it hasn't happened yet. The first quarter proved brutal to many public i-shops. Even Digitas, which as recently as three months ago was predicting growth, revised its projections for 2001 from 20%-25% revenue growth to 0%-6%.

With the dot-com business long gone, the continuation of the decline can now be attributed to the tightening economy. Even a Web stalwart like Delta Air Lines, a longtime Modem Media client, is being cautious. "We're making sure everything we deem as a major project is an absolute necessity," says Rob Casas, general manager of business-to-consumer e-business at Delta. This year, he has had to choose between expenditures, such as Internet advertising or product development, for example.

AN UNCERTAIN FUTURE

Agency.com's 2000 annual report details industry perils: "We may be unable to adjust our cost structure quickly enough to offset unexpected revenue shortfalls due to the fact that many of our costs are fixed or are associated with commitments which cannot be immediately terminated, which could cause our operating results to suffer."

Just 18% of Agency.com's 2000 revenues come from retainer relationships; the remainder is based on time and materials or fixed-fee contracts. Many other i-shops operate on similar ratios. Compounding the problem is that most i-shops didn't maintain sales forces when business was good. When business slowed, they had no process for replacing revenue.

"One manager [at an i-shop] said, `Why do I need a direct sales force when business is knocking down the door?"' says Rich Young, an analyst with the Yankee Group. "That's why the business mod el is failing."

Agency.com chairman-CEO Chan Suh agrees with that assessment: "We've had to emphasize certain areas more than we have before. Sales and business development is one."

Can all this rush to reorganize enable the industry to survive? No one is saying that it will go away, just as no one is saying the Internet will go away. Still, as the carnage continues, there's little agreement as to who will emerge as the winners.

Many observers think the traditional consulting firms will come on strong, taking business that used to be for the i-shops, or alternatively, buy them. But, the management consultants aren't immune to the market downturn.

PricewaterhouseCoopers, for example, last month laid off 6% to 8% of its staff, citing client cutbacks in tech spending. And the only concrete evidence that consultants have interest in the industry is the consortium announced in January combining traditional shop Citron Haligman Bedecarre with Washington, D.C.-based Magnet Interactive, London i-shop AKQA and Asian new media shop The ADInc. The new company has financing from Accenture.

Mr. Suh takes particular exception to the potential encroachment of consulting firms on his business. "It's easy to say Ernst and Young is going to crush Agency and Sapient and all those people," he says. "That's not true."

But the events of the last year show that the future lies with those that have solid client relationships. "In the short term, the demand for e-consultancy services has completely dried up," contends Carla Hendra, president of WPP Group's OgilvyOne North America, parent of Ogilvy Interactive. "What that's done is ... send clients back to people that they know and trust." Namely, their ad agencies.

Boston-based Digitas doesn't have big agency backing. Yet, as a descendant of direct marketing shop Bronner Slosberg Humphrey, it has had success serving Fortune 100 clients, just as it did as a direct marketing shop.

David Kenny, Digitas' chairman-CEO, admits, however, that the shop has been affected by the downturn: "We grew at a slower rate, but we're not declining at the rate that these other people are." Digitas' forecast that it might be its revenue might be flat in 2001 would spell trouble in other industries.

But, in this market, flat is good.

TWO WRONGS DON'T MAKE A RIGHT

One scenario might be for some weaker companies to merge. But experts downplay the idea.

Mr. Alpert is hard-pressed to come up with a list of i-shops that he thinks will be successful. Of 20 companies on his watch list, only Sapient, DiamondCluster and Proxicom seem strong, he says. All are technology-focused.

By and large, analysts feel that ad agencies are more likely to hire away displaced workers than they are to buy a company outright, but some, including OgilvyOne and Tribal DDB are shopping. "What we look for are companies that would give us additional markets to participate in," says Ms. Hendra.

Other potential buyers could come from the tech sector. There's been speculation that Hewlett-Packard Co. would acquire struggling Scient-though strongly denied by both sides.

SURVIVAL OF THE SPECIALIST

Still, one key to staying alive may be to specialize. Now, companies that once offered everything are rethinking that approach. "You had this huge `We can do anything for you anytime, anybody' mentality," says Kate Everett-Thorp, CEO of Lot21, San Francisco. Her company's focus on providing online advertising services enabled Lot21 to remain relatively healthy, she contends.

"The market's asking you to specialize, which is fine," agrees Jonathan Nelson, chairman of Organic. Mr. Nelson says that as the firm focuses on its core expertise it is "being a little more explicit" about potentially partnering with others who have more specialized services. Organic is currently in alliance talks with Omnicom sibling BBDO.

"A lot of firms had expertise in interactive marketing and really had no idea how to tie into the [client's] back end," says Yankee's Mr. Young. "That's why you're now seeing [i-shops say] we're focused on this industry or that industry..."

Despite i-shops' hunt for stability, it will take a while to see who survives. It's something only the passage of time can resolve.